Last month, many of the leading foreign exchange banks gave
their support to the launch of a new spot FX trading platform.
Built and delivered by interdealer broker
Tradition,
ParFX will compete with
EBS and Thomson Reuters, the two venues with the biggest
market share in the wholesale FX market, where the biggest
participants make markets to each other.

The new platform was born out of frustration among the big
banks at being picked off by high-frequency traders employing
latency arbitrage, notably on EBS. It was designed to hold all
participants to the same rules in maintaining firm two-way
prices to each other. It is striking that the 11 founding
banks, including three of the top four in
Euromoneys 2013 foreign exchange survey, carried on
with the venture even after EBS bowed to their pressure to
reform its rules.

Banks now say that what began as a stick to beat EBS into
submission over facilitating latency arbitrage for the
high-frequency traders has become something else: a means to
prevent EBS and Thomson Reuters exerting duopoly pricing power.
Leading banks talk up the price-and-efficiency benefits from a
dose of healthy competition in the marketplace for wholesale
venues. Tradition stresses the low costs of hooking up to
ParFX, as well as the low costs per trade, as much as its
usefulness for
ensuring a level playing field for liquidity providers.

The widespread expectation is that before long Citi, the
only one of the top-four FX banks by market share of customer
volume not in
the founding group behind ParFX, will join its peers 
Deutsche, Barclays and UBS  on the new platform. These
four banks have over 50% of the market between them, while Citi
and Deutsche, the top two banks, have 30%. Thats not
quite the same level of market share EBS and Thomson Reuters
command of the inter-professional liquidity marketplace, but
its not far off.

The leading FX banks customers should take note of the
banks evident aversion to submitting to the potential
pricing power of such dominant providers. Regulators should
take a look too. The vast FX market, so essential to the
functioning of so many other financial markets and a key
underpinning of the global financial system, looks set to
become even more dependent on a small handful of banks whose
failure might pose systemic consequences. The banks themselves
are even worried about this, especially in the FX derivatives
markets, where regulatory and IT costs are rising, competitors
are withdrawing and volumes rising as volatility returns.

In the financial crisis five years ago,
the FX market performed resiliently. Would it still do so
under conditions of extreme stress, say a
euro break-up coinciding with a bank-funding panic? Would
the diminishing number of wholesale liquidity providers in spot
and FX derivatives be capable of committing the risk capital to
absorb risk in a high-volume, volatile currency market?

Press them on this privately and many sources at the leading
FX banks express their doubts. Of course, they wont say
so too loudly or publicly. Concentration of market share
isnt something to be discouraged when your bank is the
beneficiary.

Further reading on Euromoney

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